Interest rates are rising; easy money is over; the cracks are showing. UK pensions were the first big explosion. FT experts and financial industry insiders examine where the next big threats to the global financial system lie and explain why when the tide goes out, we can see who is swimming naked
Produced, directed and edited by Daniel Garrahan. Filmed by James Sandy, Gregory Bobillot and Petros Gioumpasis. Graphics by Russell Birkett. Colour and audio by CodaTOMMY STUBBINGTON: This is a story of a world that became addicted to low interest rates.KATIE MARTIN: Investors have just been spoiled for like two decades by super low interest rates, and it's over. The game is up. Inflation is here for the first time in most investors' living memories. And this changes everything.
DAVID OLDER: The result of that was the need for incredible liquidity injections into the financial system. DAVID OLDER: And that did set forth a paradigm, if you will, of inexpensive money and a feeling that there was a Fed put below the markets. The Federal Reserve and central banks globally were able to achieve this because there was no inflation.
JIM LEAVISS: The global financial crisis followed by a eurozone crisis followed by COVID-- three big things coming in rapid succession. In a way, we've almost forgotten what normal looks like. TOMMY STUBBINGTON: We've ended up in a world where inflation's at 10%. Now what we have is central banks around the world scrambling to stop inflation running away.
TOMMY STUBBINGTON: You can no longer buy up government debt every time there's a wobble in the markets because you need to concentrate on your main mission, which is fighting inflation. HARRIET AGNEW: The market freaked out because essentially the government was saying, we need to borrow much more money at a time where it's going to get even more expensive to borrow money. This drove a sharp sell-off in the UK government bond market. The speed and scale of the move in the gilts market was unprecedented, and this is what caused a shock.
Now one way that they can protect themselves against that is by owning lots of gilts-- gilts, long-term government bonds, that will also see wild swings in their prices as long-term interest rates move. That works if you are able to fill your pension portfolio with 100% gilts. In practise, it doesn't work that way. There are shortfalls in the funding of these schemes, so they need to buy riskier assets as well.
JIM LEAVISS: As gilt yields climbed rapidly in the wake of the budget, that meant that those swapped positions, moved against the pension funds. The type of moves that are supposed to be only seen once in a generation in the gilt market-- we had that happening three days in a row. JIM LEAVISS: The Bank of England announces that it's prepared to buy up to 65 billion pounds' worth of gilts, of long-term gilts, over the next 13 days, which effectively looks like a return to the days of quantitative easing precisely at the time when they're trying to back away from policies like that.
TOMMY STUBBINGTON: Central banks like the Bank of England wear two different hats. One of them is to set monetary policy and control inflation, and the other one is to protect financial stability. Now for most of the last decade, those two things have worked pretty well hand in hand. When you had no inflation and low interest rates, it was easy to ride to the rescue on financial stability grounds without compromising your monetary policy. With high inflation, you can't do that anymore.
MEGAN GREENE: It's a great metaphor for where we are now, because as the liquidity is withdrawn, we can see where all the vulnerabilities are because they're going to blow up. HARRIET AGNEW: After the financial crisis, global regulators did a lot of work to make the banks safer, as a lot of the risk got pushed away from the banking sector into what we call the shadow banking sector-- non-bank players such as hedge funds, private equity, pension funds, and asset managers, the unregulated parts of the financial sector. Before the financial crisis, regulators knew that most of the leverage was in the banks.
TOMMY STUBBINGTON: The European Central Bank has to set policy for lots of countries. That means one of the things that they're really worried about is the gaps opening up in bond markets between what it costs different countries to borrow. And this is particularly for countries with weaker economies like Italy or Greece. So far, they've been able to get away with the threat of buying more Italian bonds to stop this happening.
TOMMY STUBBINGTON: Lots of participants in that market have been complaining that liquidity is getting worse, that it's harder to trade bonds without moving the price, that sometimes it's simply impossible. That's a worrying sign when you're talking about a market that's so fundamental to the global financial system.
KATIE MARTIN: The nightmare scenario honestly, is that we get anything like the sort of volatility that we've seen in gilts happen in US Treasuries. KATIE MARTIN: The logical conclusion is that there's simply no way that US authorities would stand back and let that happen. But yields can rise because prices are falling in bond markets much more quickly than we have become used to. So if you have modelling for any kind of hedging contract, anything that's predicated on rates moving slowly, I would suggest you check the fine print on that pretty quickly.
COLBY SMITH: Chair Jay Powell acknowledged the fact that a recession is a real possibility. And he said something that I think really shocked investors. Everyone wants there to be a painless way to bring inflation down, and there just isn't. And we constantly hear them reference this 1970s period when inflation got out of control because policymakers prematurely eased policy. And that's just not a mistake that they're willing to make this time around.
The big question that investors are asking is, can Japan do this? Can it pull this off without lighting a fuse under the massive Japanese government bond market? Lots of people have spent years looking for some sort of disaster in the Japanese government bond market, and they've been disappointed. But what is to say that that market can't do this? And what is to say what the reaction of Japanese asset managers would be to that? Nobody knows the answer to these questions.
MEGAN GREENE: UK specifically I think the mortgage market is a bit of a risk as well, just because the Bank of England will have to hike rates aggressively. And most mortgages are pretty short-term in the UK relative to the US. You could end up having these fixed-term mortgages turn variable with much higher rates. That could blow back on the banks.
TOMMY STUBBINGTON: When you can't earn a decent yield, a decent interest rate, from buying the safest assets, it pushes you into more dangerous areas, encourages you to take on leverage. You use borrowed money to juice up your returns. COLBY SMITH: The situation is going to get much dicier. We heard this from the IMF. The worst is yet to come for the global economy and the global financial system. That's pretty strong language.TOMMY STUBBINGTON: We saw with the UK pensions crisis that the central banks still are able to step in and stop the worst problems without compromising their commitment to fighting inflation.
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